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Explore the concept of uncertainty and its implications in decision-making. Learn about different theories of probability and the distinction between risk and uncertainty. Gain insights into how uncertainty affects economic and financial situations.
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UNCERTAINTY AND INSTABILITY Hasan Ersel HSE May 21, 2011
WHAT IS UNCERTAINTY? Uncertainty results in ignorance. It is essentially an epistemic property induced by a lack of information.
A DIGRESSION: IMPRECISION AND UNCERTAINTY • Suppose the official estimate for the GDP growth rate for Country A is 4,5% in 2007. Consider the following statements • “The rate of growth of the GDP of Country A is certainly above 3,5 % in 2007, I am sure about it.” Imprecise but certain... 2) “GDP of Country A increased 4,5 % in 2007, but I am not sure about it.” Precise [in fact true] but not certain... 3) “I am sure that in the 2007 the GDP growth in Country A was 6 %” It is both precise and certain, but it is not true. (You believe that the GDP growth rate was 6 % which was, in fact, only 4,5%)
CLASSICAL PROBABILITY THEORY • The classical theory Lapalce’s definition of probability, based on the assumption that a fundamental set of “equipossible events” exists (like in the case of games of chance, dice etc.). The probability of an event is then the ratio of the number of cases it occurs to the number of all equipossible cases. • Relative Frequency Theory Probability is essentially the convergence limit of relative frequencies under repeated independent trials. This pragmatic argument explains its popularity.
SUBJECTIVE (BAYESIAN) PROBABILITY For the Bayesian school of probability, the probability measure quantifies one’s belief that an event will occur, that a proposition is true. It is a subjective, personal measure. “Probability is degree of belief”
SUBJECTIVE PROBABILITY Some economists argue that there are actually no probabilities out there to be "known" because probabilities are really only "beliefs". In other words, probabilities are merely subjectively-assigned expressions of beliefs and have no necessary connection to the true randomness of the world (if it is random at all!).
KOLMOGOROV’s AXIOMATIC APPROACH TO PROBABILITY • The probability (P) of some event (E), denoted P(E), is defined with respect to a "universe" or sample space (Ω) of all possible elementary events in such a way that P must satisfy the Kolmogorov Axioms. • [Kolmogorov’s famous book on probability is Foundations of the Theory of Probability (1933)]
KOLMOGOROV’s AXIOMS • First axiom For any set E, the probability of an event set is represented by a real number between 0 and 1. • Second axiom The probability that some elementary event in the entire sample set will occur is 1, or certainty. More specifically, there are no elementary events outside the sample set. • Third axiom The probability of an event set which is the union of other disjoint subsets is the sum of the probabilities of those subsets. This is called σ-additivity. If there is any overlap among the subsets this relation does not hold.
KEYNES’S APPROACH TO PROBABILITY John Maynard Keynes Keynes was concerned with situations where frequency probability cannot be used. In this case, the use of intuitive probabilities can help understand the rationality in this kind of situation. The intuitive thesis in probability asserts that probability derives directly from the intuition, both in its meaning and in the majority of laws which it obeys. Contrary to the common use of probability, the intuitive approach claims that experience should be interpreted in terms of probability and not the inverse. Thus, intuition comes prior to objective experience.
KEYNES’ VIEW OF PROBABILITY-1 • Keynes interpreted probability differently from chance or frequency. Probability is a logical relation between two sets of propositions • The measurement of probabilities involves two magnitudes: the probability of an argument and the weight of the argument • Measurement of probability means comparison of the arguments, for such a comparison is “theoretically possible, whether or not we are actually competent in every case to make”
KEYNES’ VIEW OF PROBABILITY-2 • Keynes was well aware that the probabilities of two quite different arguments can be incomparable. • Probabilities can be compared if they belong to the same series, that is, if they “belong to a single set of magnitude measurable in term of a common unit” • Probabilities are incomparable if they belong to two different arguments and one of them is not (weakly) included in the other
KNIGHTIAN DISTINCTION BETWEEN RISK AND UNCERTANITY • According to Frank Knight (1921, p. 205): "Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated.... The essential fact is that 'risk' means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomena depending on which of the two is really present and operating.... It will appear that a measurable uncertainty, or 'risk' proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all”
RISK CALCULATION Risk = p.x p=The probability that some event will occur x= The consequences if it does occur Question: What happens if p is a very small number and x is a large negative number (corresponding to a hazard) ? Such as the occurance of a financial crisis!
SUGGESTED POPULAR TEXTS Bernstein, Peter L.: Against the Gods-The Remarkable Story of Risk, New York: John Wiley & Sons, 1996. Mandelbrot Benoit B. & Richard L. Hudson: The (Mis) Behavior of Markets-A Fractal View of Risk, Ruin and Reward, Basic Books, 2004. Taleb, Nassim N.: The Black Swan, New York: Random House, 2007.
RATIONAL EXPECTATIONS • According to John Muth, who developed the rational expectations theory in 1961, • “Expectations will be identical to optimal forecasts (the best guesses of the future) using all available information” • He used the term to describe the many economic situations in which the outcome depends partly upon what people expect to happen.
EXPECTATIONS AND OUTCOMES • The concept of rational expectations asserts that outcomes do not differ systematically (i.e., regularly or predictably) from what people expected them to be. • This is an important hypothesis from economic policy-making point of view. Consider the following statement by Abraham Lincoln: • "You can fool some of the people all of the time, and all of the people some of the time, but you cannot fool all of the people all of the time."
RATIONAL EXPECTATIONS AND MAKING ERRORS • Rational expectations theory does not deny that people often make forecasting errors, but it does suggest that errors will not persistently occur on one side or the other. • Even though a rational expectation equals optimal forecast using all available information, a prediction based on it may not always be perfectly accurate.
REASONS WHY EXPECTATIONS MAY FAIL TO BE RATIONAL • People may be aware of all information but find it takes too much effort to make their expectation the best guess possible (the cost of information processing) • People might be unaware of some available relevant information, so their best guess of the future will not be accurate. (asymmetric information)
IMPLICATIONS OF THE RATIONAL EXPECTATIONS THEORY • If there is a change in the way a variable moves the way in which expectations of this variable are formed will change as well • The forecast errors of expectations will, on average, be zero and can not be predicted ahead of time.
THE EFFICIENT MARKET HYPOTHESIS • The so-called Efficient Market Hypothesis is in fact an application of rational expectations to the pricing of stocks and other securities. • Efficient markets hypothesis can be expressed simply as: “in an efficient market, a security’s price reflects all available information.”
EFFICIENT MARKETS HYPOTHESIS-MAIN ARGUMENTS • A sequence of observations on a variable (say daily stock prices) is said to follow a random walk if the current value gives the best possible prediction of future values. • The efficient markets hypothesis uses the concept of rational expectations to reach the conclusion that, when properly adjusted for discounting and dividends, stock prices follow a random walk.
INFORMATION AND OUTPERFORMING THE MARKET • Information or news, in the efficient market hypothesis, is defined as anything that may affect prices that is unknowable in the present and thus appears randomly in the future. • The efficient market hypothesis states that it is not possible to consistently outperform the market by using any information that the market already knows, except through luck.
FORMS OF EFFICIENCY • WEAK:No excess returns can be earned by using investment strategies based on historical share prices or other financial data. Current share prices are the best, unbiased, estimate of the value of the security. • SEMI-STRONG:Share prices adjust within an arbitrarily small but finite amount of time and in an unbiased fashion to publicly available new information, so that no excess returns can be earned by trading on that information. • STRONG:Share prices reflect all information and no one can earn excess returns.
STRONG-FORM OF EFFICIENCY • If there are legal barriers to private information becoming public, as with insider trading laws, strong-form efficiency is impossible, except in the case where the laws are universally ignored. • To test for strong form efficiency, a market needs to exist where investors cannot consistently earn excess returns over a long period of time. Even if some money managers are consistently observed to beat the market, no refutation even of strong-form efficiency follows.
THE NATURE OF ECONOMIC LIFE AND UNCERTAINTY • Economics is forward looking, • Economic environment constantly changes. Observations (data) provide only a weak basis for making generalizations and/or forecasting, • Real time matters, because most of the important decisions are irreversible, therefore mistakes can not be corrected, • Such a state of affairs encourages cautious behavior- i.e. a particular attitude towards the likelihood of events.
POST KEYNESIAN VIEW-1 • Post-Keynesians argue that Knightian "uncertainty" may be the only relevant form of randomness for economics - especially when that is tied up with the issue of time and information. • In contrast, situations of Knightian "risk" are only possible in some very contrived and controlled scenarios when the alternatives are clear and experiments can conceivably be repeated.
POST KEYNESIAN VIEW-2 • In the "real world" economic decision-makers usually face with situations that are almost unique and unprecedented. In most instances the alternatives are not really all known or understood. • In these situations, mathematical probability assignments usually cannot be made. Thus, decision rules in the face of uncertainty ought to be considered different from conventional expected utility.
RATIONAL INATTENTION THEORY • Under rational inattention theory (Christopher Sims), information is also fully and freely available, but people lack the capability to quickly absorb it all and translate it into decisions. • Rational inattention is based on a simple observation: Attention is a scarce resource and, as such, it must be budgeted wisely. • Individuals choose bits of information according to their interests; risk aversion may induce people to process negative news faster than positive news.
Unstable Neutrally stable. Assumes new position caused by the disturbance. A cone resting on its base is stable.
DEFINITION OF STABILITY • A system is said to be stable if it can recover from small disturbances that affect its operation
STRUCTURAL STABILITY • In mathematics, structural stability is a fundamental property of a dynamical system which means that the qualitative behavior of the trajectories is unaffected by small perturbations. • Structural stability deals with perturbations of the system itself, in contrast to Lyapunov stability which considers perturbations to initial conditions for a fixed system. • Structurally stable systems were introduced by Aleksandr Aleksandrovich Andronov (1901 –1952) and Lev Semanovich Pontryagin (1908-1988) in 1937 under the name of rough systems.
STRUCTURAL INSTABILITY • Structural instability focuses mainly on the structural properties of the object to which it refers. • A system is structurally unstable if it is liable to change very rapidly the qualitative characteristics of its structure. • Since there is often a strict correspondence between the structural properties of a certain object and the qualitative characteristics of its dynamic behavior, structural instability generally implies also a radical and swift change in the latter, and vice versa.
RELAXED STABILITY • In aeronautical engineering, relaxed stability refers to airplanes with no inherent natural stability. • Relaxed stability is the tendency of an aircraft to change its attitude and “angle of bank” on its own accord. • An aircraft with relaxed stability will oscillate in simple harmonic motion around a particular attitude at an increasing amplitude. • Lowering stability allows the plane to be designed purely for aerodynamic efficiency, as opposed to handling or "flyability", and can have noticeable performance improvements in some designs.
HOW ONE STRUCTURALLY UNSTABLE AIRCRAFTS FLY • Aircraft which are built to exhibit structural instability in the form of “relaxed stability” are controlled by a highly sophisticated computer based “fly-by-wire” system. • A more advanced “fly-by-light” system is also developed.
